46% spike in gas price just doesn't make sense

In many areas of the economy, there looms the specter of deflation, with consumer prices falling over the past 12 months by their greatest percentage since 1955.

But you might not notice that fall in prices next time you fill up your tank with gasoline. Instead of deflating, gasoline is inflating. The big question is why.

Last week, gasoline prices rose above $2.50 per gallon in San Diego County for the first time since early November. Prices are now above the $2.25 mark nationwide.

That's a 46 percent jump in just five months, up from a recent low of $1.71 last December. By July 4, analysts say, gasoline could surge above $2.50 nationwide and as high as $2.75 in San Diego County. Some analysts say it would not be surprising to see the price at some local gasoline stations creeping back toward the $3 mark.

“The major oil companies are betting prices will go up, and go up quite high,” said Charles Langley, fuel analyst at San Diego's Utility Consumers'Action Network.

Langley noted that gasoline prices always rise in springtime, after refineries shift from their cheaply produced “winter blend” of gasoline to a more refined “summer blend.” But the change in blends typically results in a price rise of 10 percent to 15 percent, not the 46 percent hike that we're currently experiencing.

So why are gas prices rising when other goods are dipping? Will the price rise dissipate after the July 4 holiday? Or is the run-up a new threat to an economy that is struggling to dig itself out of recession?

If oil prices were ruled simply by supply and demand, we should not be seeing this kind of price rise.

Thanks to the Great Recession, worldwide demand for oil has plummeted. Workers who have been laid off aren't buying gas to commute to the office every day. Tourists are taking shorter trips. Businesses are putting fewer trucks on the road. In California, demand is down more than 10 percent. The International Energy Association predicts that global oil demand will average 2 million barrels per day less this year than last.

Because of the declining demand, the world's supply of oil has risen to a 19-year high. As much as 150 million barrels of oil is floating in tankers on the ocean, being kept on hold until the oil companies decide it's profitable to bring them in. Last year's chants of “drill, baby, drill” seem more meaningless than ever, given that there's more oil now being pumped than oil companies are willing to put on the market.

This conjunction of abundant supply and low demand should translate into cheap prices. But that isn't the case right now.

“The fact that oil is over $50 per barrel, much less close to $60, doesn't make sense in a pure supply and demand market,” said Judy Dugan, who tracks oil prices at Consumer Watchdog, a public interest group in Santa Monica.

“It's scary to think that if gasoline can go up this much in a completely collapsed market like this, when businesses are shutting down and people are being thrown out of jobs and economizing in every way, how much will it go up when the economy recovers? $4? $4.50?” Dugan said.

Arguably, one reason for the price rise is that gasoline ended last year too cheap. Last year, refineries were whipsawed by the rapid drop in demand for oil. By December, they were selling gas at a loss. So they've slowed their production.

Refineries on the West Coast are now running at about 80 percent of capacity, down from a five-year average of more than 90 percent. Tesoro Corp., which runs seven refineries across the nation, cut production 10 percent in the first quarter and last week announced it would lower its production even more.

Wall Street speculators have also driven prices higher. Based on signs that the U.S. economy may be bottoming out and that demand for oil will soon pick up in China and India, they have been snapping up derivatives tied to the idea that oil prices will rise in coming months.

“What really makes oil prices go through the roof is these speculators, who never touch a gallon of gas or barrel of gasoline, but who buy these derivatives,” Dugan said.

Last year, speculators helped push the price of oil to $140 per barrel, convinced that oil supplies were constricting worldwide and that demand would continue unabated. When the worldwide recession cut demand, speculators fled from the market.

James Hamilton, economist at the University of California San Diego, downplays the effect of speculation on the market.

“There is a potential for speculators to get their calculations wrong, and they clearly were wrong in the summer of 2008,” Hamilton said. “But I don't think you can view them as the ultimate, determining factor for how prices rise. To a certain extent, they're merely a distraction.”

On the other hand, Hamilton is concerned that the upward drift in oil prices could be an early warning sign of inflation. Because of rising transportation costs, gasoline prices are already contributing to the rising price of food, which rose 1.6 percent last month.

It's unlikely that inflation will get out of hand while the global economy is still in recession. But the current price rises could be a harbinger of inflation to come, Hamilton said. And if oil rises too high, too fast, it could bring about another dip in the economy.

In a research paper Hamilton presented at the Brookings Institution recently, he argued that the rising price of oil in the past couple of years was one of the major contributing causes of the current recession.

The spike in oil prices, he said, helped lead to the crash of Ford, General Motors and Chrysler, which pushed unemployment up and shaved half a percentage point off the gross domestic product.

Rising oil prices were also a key factor in the decline of consumer sentiment, which preceded a cutback in spending, further slowing economic growth, he said.

Most economists don't expect inflation to be a problem for at least another year or two. Deflation is the major concern right now. But Hamilton said it's not too early to keep an eye on oil prices to make sure that they won't derail the economy.

“This should be a wake-up call to the Federal Reserve,” Hamilton said. “There's just so much you can hope to accomplish through monetary policy. If we see other prices rise, it should be a stop sign to monetary expansion.”